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Inflation Soars — But Wall Steet Ignores It

Wall Street is relieved that inflation is under control. Consumers know it isn’t.

Share prices are soaring today, on the good news that the core consumer price index was up just 0.1 percent in May. Economists are ignoring the fact that the overall C.P.I was up 0.7 percent.

The core figure leaves out food and energy, and since that is the rate the Federal Reserve watches, traders think there is little risk of a Fed move to tighten. The theory is that food and energy numbers can be volatile and thus misleading.

The trouble with only watching the core rate is that real people eat and also use energy. And changes in those prices are important over long periods of time.

Over the past three months, the total consumer price index has risen at a high annual rate of 7 percent, while the core rate is advancing at the small rate of 1.6 percent.

To be sure, three months is a short period. But four years is not. Over that period, the overall CPI is up at an annual rate of 3.15 percent, a full percentage point more than the core rate. Food is up at a 3.1 percent rate, a 13 year high for that measure. And energy costs have risen at a 12.9 percent annual rate.

The last four-year period that saw consumer prices rise as much as they did over the last 48 months was in the period ending in August 1994. If Wall Street paid attention to the real inflation figure, the moaning would be intense.

The University of Michigan survey of inflation expectations also came out today. The median forecast is for a 3.5 percent inflation rate over the next year. The average forecast is even higher, at 4.1 percent. “Clearly,” said Robert Barbera, the chief economist of ITG, “people who are polled by the University of Michigan think they have to buy food and gasoline.”

One more interesting piece of information: The U.S. Treasury Department survey of international transactions reports that China was a net seller of $941 million worth of Treasury bonds and notes in April, after buying $13.6 billion worth in the first three months of the year. April is a funny month, given that tax receipts reduce the government’s need to borrow, but in April 2006 China bought $4.15 billion in Treasuries.

One month does not make a trend, but if China is getting hesitant about adding to its Treasury portfolio, interest rates could be headed up even if the Fed does want to ignore the actual inflation rate.

Food and energy are dropped from the core rate because they are volatile from month to month and will cause understatements and overstatements in inflation estimates based on month to month price changes. One might even argue that they should be dropped from estimates based on quarterly price changes. By the time a year passes any true volatility in food and energy prices should be long gone and the ‘core rate’ becomes a convenient way to mask real inflation.

What matters most as far as inflation goes are expectations about future inflation. The University of Michigan inflation expectations survey has remained anchored at about 3% since 2003, bar the Katrina Effect in 2005. The series is available at the following URL:

When this survey loses its 3% anchor, then inflation will become a concern for monetary policy. Food and energy inflation is ok if it is a signal that those goods are more costly relative to other goods. That is the function of a price. Increasing prices per se are not a symptom of underlying inflation. After all, prices of corn, which is used in a great deal of food products, are rising because corn is now used as an input to making ethanol. So rising food prices are partly caused by this new demand for corn. This causes food prices to rise, but is not a reason for monetary policy action.

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Economics doesn't have to be complicated. It is the study of our lives — our jobs, our homes, our families and the little decisions we face every day. Here at Economix, journalists and economists analyze the news and use economics as a framework for thinking about the world. We welcome feedback, at economix@nytimes.com.